Netflix

I am fascinated by the rise of Netflix. It’s one of the strongest performers on the stock market for the last few years. The brand is one of the few that became verbs such as Paypal or Google. The company didn’t meet the expectation from analysts the last quarter and its stock price went down significantly. Doubts were raised about the company’s outlook. I wanted to take a look to see if some of the doubts were exaggerated.

Netflix model

Netflix is booked to spend a whopping $8 billion on original content this year alone. Some may argue that it’s an incredible amount to spend on content, but it fits right in Netflix model.

Since Netflix originally licensed content for its catalogue, moving to production of original content was to hedge the risks of over-reliance on the legal owners of shows and movies. Apart from the less popular DVD segment, Netflix has only one primary revenue stream – subscriptions with no ads – there are two ways to increase revenue and profit:

Enlarge the subscription base

Increase the subscription fees

The two approaches are not mutually exclusive. In fact, Netflix has seen tremendous growth in subscriptions and increased its fees (see below). It wouldn’t make sense to expect the company to focus on the first only and to neglect the second approach. To convince people to sign up and pay more; however, Netflix has to offer sufficient values in return. It means that the user experience has to be improved constantly. There are several ways to do so:

Better recommendations

Excellent user interface

Network effect

Satisfaction with content

While the work on better algorithms, user interface, infrastructure to deliver content timely and advertising to sign up more users can result in significant investments, the majority of Netflix’s expense will go to its content library.

A war for our free time

To feel that their investment is worthwhile, my theory is that users have to spend as much time on Netflix as possible. In other words, Netflix is out to consume our free time. Let’s look at a break-down of our free time:

On average, let’s say we spend 8 hours at work and the equal amount on sleep and meals every day. That leaves us with 8 hours of free time which has to accommodate all kinds of activities, including but not limited to, the list on the right hand-side. Granted, some of us may spend less time on sleep and meal or no time on work during the weekend. On the other hand, we can argue that some may have to work long hours and spend much time on meals such as executives or those in tech or Wall Street. For the simplicity’s sake, let’s assume that is on average the breakdown of a day.

For any minute of our time, it is exclusive to one activity only, in most cases. Can you read and watch Netflix at the same time? Or listen to music while watching a show? The exception is when you watch TVs or Netflix with your family/friends or while travelling.

In other words, 8 hours of our free time is a precious real estate that service providers want a piece of and as big a piece as possible. To compete for our free time, Netflix has to compete with sports, TVs, music streaming services such as Spotify or Apple Music, news, friends and family as substitutions; all of which are to some extent indispensable in our life. On top of that, the direction competition includes HBO, Amazon Prime Video, YouTube Red (or YouTube Premium), Hulu, the upcoming Disney streaming service “Disney Play”, and Apple.

A pretty tough competition. To beat the direct rivals and substitutions, Netflix must keep regularly producing hits such as House of Cards, Orange is the Black or Stranger Things. A tall order. In the meantime, competition obviously doesn’t stand still. They understand the value of quality shows and invest heavily as well.

There is a sentiment that the entertainment service is big enough that it doesn’t have to be a zero-sum game and that multiple players can succeed. The issue; however, is that there is a limitation on free time and disposable income on subscriptions from the user perspective. If you can only afford $30-40 a month for subscription services while there are so many options such as news (WSJ, Economist…), music, food, TV and content streaming, will you pay for two streaming services a month?

What’s next for Netflix?

The below screenshots are from the 2017 Annual Report:

For domestic and international segments, Netflix has seen growth across the board from 2015 to 2017 in memberships, revenue, average monthly revenue per paying membership and contribution margin. It means that they didn’t expand their membership base by discount. The strategy seems to have been working for the past 3 years at least.

For the first half of 2018, revenue increased by 40% and operating income rose by 236% compared to the first half of 2017. The last two quarters also saw Netflix pay less for content than it did in the same period of 2017. Operating income as % of revenue already increased.

H12017

H12018

Cost of revenues

66%

59%

Marketing

11%

13%

Technology and development

9%

8%

General and administrative

7%

8%

Operating Income

7%

12%

The net membership additions slowed down compared to other quarters. For a subscription business such as Netflix, it’s a valid concern. However, the financials still look pretty positive and it remains to be seen whether this hiccup will be a long-term issue.

Additionally, a study by PriceIntelligently revealed that Netflix has some cushion to increase their subscription fees even more.

Netflix could increase their top & bottom line if they wanted to either by features or by country. However, I doubt that they would prioritize doing it. Everything seems to be working well for them as you can see from the financial reports. So why would they risk losing subscriptions for short-term gains?

Summary

Things are looking positive for Netflix. Customers are happy. Popular show creators were signed. Nominations are flying in. Financials have grown. Netflix also has a lot of room for growth both in terms of subscription base, especially internationally, and prices. All signs point to a recipe for continued success in the near future.

Nonetheless, I am still concerned about the growing sizeable debt and the constant pressure of delivering hits. A lot of Netflix’s future success will hinge on its ability to feed users with reasons to sign up and stay. It’s not practical that Netflix wouldn’t have any hiccup in their content selection. In the model mentioned above, there is an assumption that Netflix’s increasing investment and show creators’ willingness to work with the company will result in more quality content. What if the assumption is incorrect?

It would be interesting to see how a year or even a few months without hits would do the health of the company. Then, we would see how much resilient the company is. Moreover, I’d love to see how many users re-subscribe again after cancelling their account. Even though the company is committed to being an ads-free streaming service of shows and movies for now, who’s to say definitely that they won’t change nor add more revenue streams to the fold?

The competition is going to get more difficult and there is no guarantee how the company will be. But the recent performance and the focus make me optimistic about the company’s health.